With the federal deficit now estimated to come in at $18 billion (or more), there is nervous speculation that Finance Minister Bill Morneau may go beyond the specific tax changes already detailed in the Liberal pre-election platform and introduce new measures in his March 22 budget to raise much needed tax revenue. One such measure being discussed in the financial and tax community is whether the government might raise the tax rate on capital gains.
A capital gain occurs when you dispose of property, such as a stock, bond or mutual fund, for more than you paid for it and is only relevant if you hold such investments in a non-registered account (i.e. outside your RRSP, RRIF, TFSA or other tax-preferred account).
Under the current rules, only 50 per cent of capital gains are included in taxable income, so the effective tax rate on capital gains is 50 per cent of your marginal tax rate on ordinary income, such as employment, business or interest income. For high-income earners, that means the effective marginal tax rate on capital gains in 2016 can exceed 25 per cent.
Indeed, the vast majority of capital gains are earned by the highest income earners. Take the 2013 tax year, for example, in which 27.1 million tax returns were filed. Of those, less than 10 per cent reported having any taxable capital gains at all. When you dig deeper into who realized the $20.4 billion in aggregate taxable capital gains that year, we find that 75 per cent of those gains were earned by those reporting income of more than $100,000 that year, or the top eight per cent of tax filers. Perhaps more staggering is that just over half of the total dollar reported taxable gains earned in 2013 were realized by those making over $250,000 annually, less than the top 1 per cent of income earners.
According to the recently released “Report of Federal Tax Expenditures (2016),” the partial inclusion of capital gains for individuals and corporations will result in a tax cost to the government in 2016 estimated at $12.1 billion.
Of course, prior to Jan. 1, 1972, Canada didn’t tax capital gains at all. That changed following the Carter Commission Report, which recommended 100 per cent taxation of capital gains. But the law, as originally introduced, only taxed 50 per cent of capital gains. The inclusion rate was increased to 66 2/3 per cent in 1988, rose to 75 per cent in 1990, before dropping back down to 66 2/3 per cent on Feb. 28, 2000 and then further reduced on Oct. 18, 2000 to 50 per cent, where it has remained to this day.
Keep in mind that some capital gains are still entirely tax-free, such as the gain on your principal residence or the gain where appreciated publicly-traded securities are donated to a registered charity. The other category of tax-free gains is in the form of the lifetime capital gains exemption (LCGE). While each Canadian used to be entitled to a general $100,000 LCGE, this general exemption, introduced by the Conservatives in 1984, lasted for only a decade and was repealed by the Liberals in 1994. Today, the LCGE is only available to farmers and fishers (on $1 million of lifetime capital gains) or shareholders of qualified small business corporations (on $824,176 of lifetime capital gains).
So if you fear an increase in the capital gains inclusion rate, do you take the risk of realizing capital gains prior to March 22? Most tax practitioners will caution against it, arguing that paying tax prematurely without knowing for sure if the rate will actually rise is too big a price to pay if you’re wrong. And besides, who’s to say the government couldn’t apply a higher capital gains inclusion rate retroactive to Jan. 1, which would make any premature realization look even more foolish.